An investor’s guide to equity crowdfunding

Very low interest rates, stubbornly high fund management fees and tepid performance from equity markets have presented investors with a dilemma – where to invest any spare cash. One relatively recent alternative that has captured the public’s interest is crowdfunding.

Broadly speaking, crowdfunding is a group of individuals (the “crowd”) pooling their money to support other individuals or companies. Crowdfunding comes in three flavours, determined by what the investor receives for their cash – lending, rewards and equity.

Equity is the only form of crowdfunding allowing investors to benefit from the success of the company, as investors receive actual shares in the company and a share of all future profits. The UK is at the forefront of the equity crowdfunding revolution that is taking place as the most ambitious businesses look to attract the support of investors. For more background information about the other types of crowdfunding visit the UK Crowdfunding Association website. 

As the founder of ShareIn, a tech focused equity crowdfunding platform launching in September, I know how important it is to make sure that people know precisely what is involved in equity crowdfunding so that they can then make an informed decision about whether or not it’s suitable for them. So here’s my guide for investors who are wondering precisely what is involved in equity crowdfunding.

Potential returns

Let’s start with the most important thing. After all, why would you invest if you weren’t looking to make money? At its most basic, the reason for buying shares in a business – as opposed to simply lending money and charging interest, for example – is that you want to benefit if the underlying business is successful. Returns are made through a share in any sale of the company (the “exit”) or through dividends eventually (in early years these are very unlikely as funds are needed to grow).

So when looking to invest in a company you need to be comfortable with the planned exit (and length of time – see below) and the price you’re going to pay (the valuation). You may think a company sounds incredible but if the valuation is too high it’s going to be difficult to make a decent return. Companies pitching for your investment really need to justify exactly why they have valued themselves at the level they have.

Tax benefits

One of the key benefits of investing in early-stage companies via crowdfunding is that it gives you the ability to access very generous tax relief, specifically in the form of EIS (Enterprise Investment Scheme) and SEIS (seed Enterprise Investment Scheme).

EIS Relief

Investing in a qualifying company you can claim back 30 per cent of your investment off your income tax bill (up to a maximum investment of £1 million).

In addition, if you hold onto the shares for three years when you sell the shares, you are exempt from capital gains tax (CGT) and are never liable for inheritance tax. That’s very attractive when you’re dealing with high growth companies where you’re counting on a significant increase in value.

If the company fails you can offset that loss against your tax bill that year (minus any income tax relief you’ve already received). Plus, if you’ve made capital gains elsewhere, you can defer paying CGT on that if you re-invest that gain straight back into an EIS-investment. This may become even more pertinent if discussions to raise CGT and lower the threshold go ahead.

SEIS relief 

A more generous relief is also available for companies wishing to raise up to £150,000. Under SEIS, an investor can reduce their income tax bill by up to 50 per cent of investments they make of up to £100,000 a year.

Also, any unused tax deduction can be carried back to the previous year. In addition, 28 per cent CGT relief is available. This can result in certain investors totally mitigating their risk (i.e. they are protected 100 per cent of the value of their investment). There is no CGT payable on a profitable sale of the shares after three years or, if the company fails, there is further income tax relief available.

Length of time to outcome

A downside of buying shares in unlisted, early-stage businesses is the lack of liquidity – being able to realise cash in a hurry. There’s currently no established market to exchange these shares so the earlier you invest in a business, the longer the time that you’re likely to be tied into your investment. Whilst five to seven years used to be quoted as a standard length of time, the consensus is that this period of time has continued to extend in recent years.

But remember the type of businesses you’re investing in. You’re investing in the hope that the early-stage business will be successful in the medium to long term. When you’re dealing with high-growth potential businesses, the extent of that success is likely to be significant and reward those who were in at such an early stage in the company’s growth cycle. Investors typically earn an extra return (the so called liquidity premium) for taking on this risk, and can be a bonus for long term investors.

Risk: A numbers game

There’s no disputing that early-stage companies are risky. Failure is reasonably likely and therefore it’s critical that you adopt a portfolio approach to your investments. By diversifying across different businesses, the minority that achieve significant success should result in financial returns that significantly outdo the losses incurred in those that fail.

One of the key benefits of equity crowdfunding is that by investing small sums of money in a larger number of businesses it is straightforward to build up a diversified portfolio.

Invest in who or what you believe in

Investing specifically in the businesses that inspire and matter to you is great fun! Why let a middle man invest your money in a faceless corporation that you might otherwise be uncomfortable about – and pay him for the privilege? The money doesn’t even go directly to the company – it simply goes to the previous owner of the share. Investing directly in early-stage companies has a huge impact and it can be truly exciting to be involved at the start of the journey.

Conclusion

As I’ve written about before, there are many advantages to investing in early-stage businesses. Crowdfunding helps to bridge the funding gap that can be fatal to the growth aspirations of so many businesses that we all need to prosper in order to generate employment and innovate for our collective futures. In the process you can have fun choosing companies you believe in, and benefit from generous tax relief and any future success.

SOURCE: The Money Pages